Markets & Finance

Big Gains for Big Mo

"Big MO" is the global leader in tobacco behind its icon Marlboro cigarette brand, as well as the second largest food company in the world (Kraft Foods) and fifth largest brewer (Miller Brewing). The company also operates a financial services division which invests in leases, other tax-oriented financing transactions and third-party financial instruments.

The company derives its diverse earnings streams across several economically-insensitive sectors, broken down by operating income contribution as follows: domestic tobacco (31%), international tobacco (30%), domestic food(26%), international food(8%), beer (3%) and financial (2%). As a reliable generator of substantial cash flows in good times or bad, the shares have particular appeal during economic slumps. S&P sees additional positive attributes supporting the stock over the next 6 to 12 months as well.

S&P believes the company will benefit from a more tobacco-friendly regulatory environment over the next four years. The Federal government's lawsuit against the industry launched by the Clinton administration is likely to be dropped, given President Bush's publicly expressed disapproval for the lawsuit. Bush has also stated publicly that he feels the tobacco industry has had enough lawsuits and "you can't sue your way to policy." Republicans tend to vote in favor of tobacco, so we believe Bush and the congressional Republicans will most likely oppose any future increases in federal excise taxes on tobacco. In addition, Attorney General John Ashcroft and Health and Human Services Director Tommy Thompson have tobacco friendly records.

While the mountain of lawsuits against the tobacco industry has given investors cause for concern in recent years, we believe litigation risks are now materially less onerous than a year ago and should continue to improve. The most important near-term litigation threat is the Engle class action case in Florida, which resulted in a $145 billion damage award against the tobacco industry last July. The case is currently being appealed and the process could take more than two years.

With 26 favorable rulings on class actions from state and federal courts in the past three years, we view the damage award in Engle as an aberration and likely to be overturned on appeal. We continue to believe that personal injury cases do not pose a significant threat to the tobacco industry and that an occasional adverse verdict is not significant in the context of MO's massive cash flow. The industry's legal defensives remain strong, and the industry should continue to win the majority of personal injury cases that go to trial. S&P believes that investor focus is now shifting away from legal problems to MO's strong business fundamentals.

The company continues to expand its dominant position in the U.S. cigarette market, and now has a 50.5% market share. The company's Marlboro brand extended its leading share position to 37.1% of the U.S. cigarette market in 2000. We believe profits from the domestic tobacco business will advance at a 5-6% rate in 2001, as recent price increases (up 6-7%) should more than offset any volume declines on the overall business.

While the industry will likely experience its historical 1-1.5% decline in annual cigarette consumption, MO brands should continue to outpace the industry and the recent pricing actions increase the likelihood that tobacco earnings will remain on target. The company's global tobacco operations remain fast growing and highly profitable. With the global cigarette market resuming its long term growth trend as developing economies continue to improve, we see 4-6% volume growth and 10% profit growth for MO's international tobacco business in 2001.

The company recently completed the $19.2 billion acquisition of Nabisco, and is now preparing for the initial public offering of its Kraft foods business. We believe the IPO of the newly merged Kraft/Nabisco global food operations could be a catalyst as a public value is assigned to this segment providing greater transparency to the value of MO's food assets. MO plans to sell 10-15% of Kraft during the second quarter of this year, with the majority of the proceeds to be used to pay down the short-term debt which financed the Nabisco acquisition. We expect the road show to begin soon, which should pique investor interest.

Free cash flow remains enormous, and should continue to be returned to shareholders through generous dividend (4.5% yield) and share repurchase programs, as well as periodic strategic investments. S&P expects free cash flow before dividends to exceed $8.0 billion in 2001, and $9.2 billion in 2002. The company repurchased $3.6 billion of stock in 2000, and should purchase an additional $3.5-$4.0 billion in 2001. Longer-term, annual share repurchases are projected to be in excess of $3.5 billion.

MO is currently trading at about 11 times our 2001 EPS estimate of $4.12 (includes $0.10 dilution from Nabisco acquisition), an approximate 50% discount to the P/E for the S&P 500 Index despite our expectation for 12-14% EPS growth for next 3-5 years. Also currently trading at approximately six times our 2001 EBITDA estimate of $20.1 billion compared to eight times for its global tobacco peers, more than 10 times for its packaged food peers, and more than 12 times for its brewing peers.

Using comparable ratio analysis and assigning an appropriate multiple to the expected cash flows by division, our breakup analysis suggests a price of $64 a share. Additionally, a discounted cash flow analysis for the individual operating units puts a value on the shares in the mid-$70 range, suggesting appreciation potential in excess of 50% from current levels. Given Philip Morris' strong operating fundamentals and defensive appeal, we are recommending purchase with a 12-month target price of $65. Joy is tobacco analyst for Standard & Poor's